The Changing Behavior of the Term Structure of Interest Rates*

We reexamine the expectations theory of the term structure using data a t the short end of the maturity spectrum. We find that prior to the founding of the Federal Reserve System in 1915, the spread between long rates and short rates has substantial predictive power for the path of interest rates; after 1915, however, the spread contains much less predictive power. We then show that the short rate is approximately a random walk after the founding of the Fed but not before. This latter fact, coupled with even slight variation in the term premium, can explain the observed change in 1915 in the performance of the expectations theory. We suggest that the random walk character of the short rate may be attributable to the Federal Reserve's commitment to stabilizing interest rates.